It seems, every financial pundit keeps touting the benefits of diversification. Almost every author on the
subject of stock market investing proclaims that one needs to be
adequately diversified. Even investors advocating a focused approach (say for instance Mohnish Pabrai) suggest that
some level of diversification is necessary.
The only two people who don’t advocate wide diversification are Warren Buffet and Charlie Munger. But even then
they approve of SOME level of diversification.
Benjamin Graham, on the other hand, advocated and practiced wide diversification. I had, in the past, practice
wide diversification and would absolutely vouch that it works.
But what
level of diversification is adequate for an individual investor?
- Should one take a “as diversified as possible” approach (a.la Benjamin Graham and Walter Schloss)?
- Should it be about 20 stocks (as suggest by many contrarians)?
- Should it be about 10 stocks (a. la. Dhando Investor)?
- Should it be about 5 stocks (a. la. Charlie Munger)?
- What level of diversification is right for you?
I have some thoughts on this …
First, realize that the rules given by others don’t necessarily apply to you. Most of the books written by
practicing investors have an inherent bias due to managing other people’s money. Many of the portfolio management
guidelines that are given are meant for people who apart from managing their own money, also manage capital on
other’s behalf.
Not only did they have to take a sensible approach, they also need to be seen and perceived as taking a sensible
approach. So quite naturally, the level of diversification suggested by most is on the conservative side – more
than what they thought was optimal.
Secondly, the asset allocation suggested by most authors, have an inherent assumption that one is trying to beat
the market – a sensible assumption but an assumption nevertheless.
What about you in particular? Is it a valid assumption?
It would be safe to say that many people are inherently not trying to beat the market. They want to do better
than the easiest and most convenient savings option – Bank FD. Beating the FD return would be more than adequate
for them. The fixed deposit rate of return is what they are competing against. It would give them very little
satisfaction if they beat the market by a handsome margin but nevertheless end up in a loss (market falls by 30%,
their portfolio falls by 10%). In fact, such a scenario would cause quite a heartburn to a lot of folks.
So again, coming back to the main question, how diversified should one be?
Well, I feel a question like this is loaded with much more context than is evident at first glance. The thing is,
over a period of time, everyone naturally gravitates to their desired and comfortable level of diversification. I
think it would take anywhere between two to five years for one to get a grip on the market (from the point when one
takes investing seriously). It takes time to understand, observe, experiment and reflect on the different
strategies put by others and relate to them with one’s own practical experience. It takes time to separate the
wheat from the chaff. It takes further time to figure out what method of investing is easy, comes naturally and is
perhaps even quite enjoyable.
However long it takes, one ultimately comes up with one’s own method of making sense of the nonsense in the
market. People who take the time to study the market and themselves come to some kind of agreement with it and
develop their own system. Such a system will be somewhat unique. Though inputs are taken from many sources, the
final mechanism of investing would be something most suited to one.
Slowly one also figures out that diversification is dependent on stock selection strategy and vice versa. It
does not exist in vacuum as an independent entity. So either their
stock selection mechanism influences the level of diversification or their chosen level of diversification
leads them to appropriate stock selection mechanism.
For instance, if I was asked to be widely diversified (say 100 stocks), I could do it (very easily). If I am
given a constraint that I can never invest in more than 1 stock at a time, I could still do it. In either case my
stock selection mechanism, my asset allocation plan, my buy and sell rules would be completely different.
My point is this: Given enough time you will figure out what works for you best – both in terms of stock selection
approach and diversification. You will understand your method and would become quite aware of the risks posed
by it as well. You investing method would evolve to be the one best suited for you.
So going back to the main question (how diversified should one be?), it is not a valid question at all.
The one that is more apt is: How diversified should I be while I am still trying to figure out the market and
come to terms with it? What is a sensible and intelligent approach?
If we look at what Benjamin Graham has said on this topic in the book, The Intelligent Investor:
There should be adequate though not excessive diversification. This might mean a minimum of ten different
issues and a maximum of about thirty.
So there you go: the answer right from Graham. Anything more than 10 stocks is reasonable, intelligent and
sensible. I would further say that when Graham wrote the Intelligent Investor, the tools available for an
individual investor was much less.
Things have become much easier and simpler for an individual investor with the advent of internet:
- Portfolio tracking websites were not available at the time of Graham – they are available to you.
- Excel sheets were not available at that time – you have access to them.
- An instant quote for stocks was not accessible to individual investors – you have them at a click of a
button.
I would venture to say that given how easy it is to research, keep track and manage a portfolio of
stocks, the higher end of number of stocks would probably be bumped up if Graham were alive today and were to
revisit the subject of diversification.
So I think anywhere between 10-50 stocks is a reasonable level of diversification. While you are still trying to
figure out your own approach, it doesn’t hurt to be slightly more diversified than you think is necessary. Even I
tout the benefits of diversification
